SENSITIVITY TO MARKET RISK Section 7.1

INTRODUCTION...... 2 TYPES AND SOURCES OF INTEREST RATE RISK .... 2 Types of Interest Rate Risk ...... 2 Sources of Interest Rate Risk ...... 2 RISK MANAGEMENT FRAMEWORK ...... 3 Board Oversight ...... 4 Senior Management Oversight ...... 4 Policies and Procedures ...... 4 Interest Rate Risk Strategies ...... 4 Risk Limits and Controls ...... 5 Risk Monitoring and Reporting ...... 5 INTEREST RATE RISK ANALYSIS ...... 5 INTEREST RATE RISK MEASUREMENT METHODS 6 Gap Analysis ...... 6 Duration Analysis ...... 7 Earnings Simulation Analysis ...... 8 Economic Value of Equity ...... 8 STRESS TESTING ...... 9 INTEREST RATE RISK MEASUREMENT SYSTEMS10 Measurement System Capabilities ...... 10 System Documentation ...... 11 Adequacy of Measurement System Inputs ...... 11 Account Aggregation ...... 11 Assumptions ...... 12 Sensitivity Testing - Key Assumptions ...... 12 Measurement System Reports ...... 14 Measurement System Results ...... 14 Variance Analysis ...... 14 Assumption Variance Analysis ...... 15 OTHER RISK FACTORS TO CONSIDER ...... 16 Interest Rate Risk Mitigation ...... 16 INTERNAL CONTROLS ...... 17 Independent Reviews ...... 18 Independent Review Standards ...... 18 Scope of Independent Review ...... 18 Theoretical and Mathematical Validations ...... 19 EVALUATING SENSITIVITY TO MARKET RISK .... 20 Examination Standards and Goals ...... 20 Interagency Policy Statement on Interest Rate Risk .... 20 Interagency Advisory-Interest Rate Risk Management 21 EXAMINATION PROCESS ...... 21 Citing Examination Deficiencies ...... 21 MARKET RISK GLOSSARY ...... 22 Deterministic Rate Scenarios ...... 22 Non-parallel Yield Curve Shifts ...... 22 Static Models ...... 22 Dynamic Models ...... 22 Stochastic Models ...... 22 Monte Carlo Simulation ...... 22 Spread Types ...... 23 Duration Calculations ...... 23 Convexity ...... 24 Effective Duration and Effective Convexity ...... 24

RMS Manual of Examination Policies 7.1-1 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

INTRODUCTION Basis risk is the risk that different market indices will not move in perfect or predictable correlation. For example, Sensitivity to market risk reflects the degree to which LIBOR-based deposit rates may change by 50 basis points changes in interest rates, foreign exchange rates, while prime-based loan rates may only change by 25 basis commodity prices, or equity prices can adversely affect a points during the same period. financial institution’s earnings or capital. For most community banks, market risk primarily reflects exposure Yield curve risk reflects exposure to unanticipated to changing interest rates. Therefore, this section focuses changes in the shape or slope of the yield curve. It occurs on assessing interest rate risk (IRR). However, examiners when assets and funding sources are linked to similar may apply these same guidelines when evaluating foreign indices with different maturities. For example, a 30-year exchange, commodity, or equity price risks. A brief Treasury bond’s yield may change by 200 basis points, but discussion of other types of market risks is included at the a 3-year Treasury note’s yield may change by only 50- end of this section. basis points during the same time period. This risk is commonly expressed in terms of movements of the yield Market risks may include more than one type of risk and curve for a type of security (e.g., a flattening, steepening, can quickly impact a financial institution’s earnings and or inversion of the yield curve). the economic value of its assets, liabilities, and off-balance sheet items. In order to effectively manage IRR, each Option risk is the risk that a financial instrument’s cash institution should have an IRR management program that flows (timing or amount) can change at the exercise of the is commensurate with its size and the nature, scope, and option holder, who may be motivated to do so by changes risk of its activities. in market interest rates. Lenders are typically option sellers, and borrowers are typically option buyers (as they The adequacy of a bank’s IRR program is dependent on its are often provided a right to prepay). The exercise of ability to identify, measure, monitor, and control all options can adversely affect an institution’s earnings by material interest rate exposures. To do this accurately and reducing asset yields or increasing funding costs. effectively, institutions need: For example, assume that a bank purchased a 30-year • Appropriate IRR policies, procedures, and controls; callable bond at a market yield of 10 percent. If market • Sufficiently detailed reporting processes to inform rates subsequently decline to 8 percent, the bond’s issuer senior management and the board of IRR exposures; will be motivated to call the bond and issue new debt at the • Comprehensive systems and standards for measuring lower market rate. At the call date, the issuer effectively and monitoring IRR; and repurchases the bond from the bank. As a result, the bank will not receive the originally expected yield (10 percent • Appropriate internal controls and independent review for 30 years). Instead, the bank must re-invest the procedures. principal at the new, lower market rate.

← Price risk is the risk that the fair value of financial TYPES AND SOURCES OF INTEREST instruments will change when interest rates change. For RATE RISK example, trading portfolios, held-for-sale loan portfolios, and mortgage servicing assets contain price risk. When IRR can arise from a variety of sources and financial interest rates decrease, the value of an institution’s transactions and has many components including repricing mortgage servicing rights generally decrease because the risk, basis risk, yield curve risk, option risk, and price risk. total cash flows from servicing fees decline as consumers refinance. Because servicing assets are subsequently Types of Interest Rate Risk measured at fair value, or carried at amortized cost and tested for impairment, the fair value adjustment or any Repricing risk reflects the possibility that assets and impairment is reflected in current earnings. liabilities will reprice at different times or amounts and negatively affect an institution’s earnings, capital, or Sources of Interest Rate Risk general financial condition. For example, management may use non-maturity deposits to fund long-term, fixed- Funding sources may involve repricing risk, basis risk, rate securities. If deposit rates increase, the higher funding yield curve risk, or option risk, and examiners should costs would likely reduce net yields on fixed-rate carefully evaluate all significant relationships between securities. funding sources and asset structures. Potentially volatile or market-based funding sources may increase IRR, especially when matched to a longer-term asset portfolio.

Sensitivity to Market Risk (7/18) 7.1-2 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

For example, long-term fixed-rate loans funded by partially or fully prepay the loan. purchased federal funds may involve repricing risk, basis • Mortgage-backed securities (MBS): Borrowers’ risk, or yield curve risk. As a result, interest rate options to prepay individual mortgage loans included movements could cause funding costs to increase in an MBS loan pool can shorten the life of a tranche substantially while asset yields remain fixed. of loans within a security.

Derivative instruments may be used for hedging but can Embedded options can create various risks, such as introduce complex IRR exposures. Depending on the contraction risk, extension risk, and negative convexity. specific instrument, derivatives may create repricing, basis, Contraction risk increases when rates decline and yield curve, option, or price risk. borrowers can refinance at a lower rate, forcing the bank to reinvest those funds at a lower rate. Extension risk Mortgage banking operations may create price risk increases when rates rise and borrowers become less likely within the loan pipeline, held-for-sale portfolio, and to prepay loans, thereby locking banks into below-market mortgage servicing rights portfolio. Interest rate changes returns. Convexity measures the curvature in the affect not only current values, but also future business relationship between certain investment prices and yields volumes and related fee income. and reflects how the duration of an instrument changes as rates change. Fee income businesses may be influenced by IRR, particularly mortgage banking, trust, credit card servicing, ← and non-deposit product sales. Changing interest rates RISK MANAGEMENT FRAMEWORK could affect such activities. The IRR management framework sets forth strategies and Product pricing strategies may introduce IRR, risk tolerances as established in the institution’s policies particularly basis risk or yield curve risk. Basis risk exists and procedures that guide the identification, measurement, if funding sources and assets are linked to different market management, and control of sensitivity to market risk. The indices. Yield curve risk exists if funding sources and framework begins with sound corporate governance and assets are linked to similar indices with different covers strategies, policies, risk controls, measurements, maturities. reporting responsibilities, independent review functions, and risk mitigation processes. Embedded options associated with assets, liabilities, and off-balance sheet derivatives can create IRR. Embedded The formality and sophistication of the IRR management options are features that provide the holder with the right, program should correspond with an institution’s balance but not the obligation, to buy, sell, pay down, payoff, sheet complexity and risk profile. Less complex programs withdraw, or otherwise alter the cash flow of the may be adequate for institutions that maintain basic instrument. The holder of the option can be the bank, the balance sheet structures, have moderate exposure to issuer, or a counterparty. Many instruments contain embedded options, and do not employ complicated embedded options that can alter cash flows and impact the funding or investment strategies. However, all institutions IRR profile of the institution, including: should clearly document their procedures, and senior management should actively supervise daily operations. • Non-maturity deposits: Depositors have the option to withdraw funds at any time. More complex institutions need more formal, detailed IRR • Callable bonds: The issuer has the option to redeem management programs. In such cases, management should all or part of a bond before maturity (based on establish specific controls and produce sound analyses that contractual call dates). address all major risk exposures. Internal controls at • Structured notes: Options can vary by the type of complex institutions should include a more thorough instrument and may include step-up features, interest independent review and validation process for the IRR rate caps and floors, and cash flow waterfall triggers. models employed, as well as more rigorous requirements • Wholesale borrowings: Lenders may have a call for separation of duties. option (requiring banks to repay borrowings), or borrowing banks may have a put option (allowing At all institutions, management and the board should them to prepay borrowings). understand the IRR implications of their business • Derivatives: Derivative owners may hold an option to activities, products, and strategies, while also considering purchase additional securities or to exercise an their potential impact on market, liquidity, credit, and existing derivative contract. operational risks. • Mortgage loans: Borrowers may have the option to

RMS Manual of Examination Policies 7.1-3 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

Board Oversight management and the board of the level of IRR exposure. Effective board oversight is the cornerstone of sound risk management. The board of directors is responsible for IRR reports should provide sufficient aggregate overseeing the establishment, approval, implementation, information and supporting details to enable senior and annual review of IRR management strategies, policies, management and the board to assess the impact of market procedures, and risk limits. The board should understand rate changes and the impact of key assumptions in the IRR and regularly review reports that detail the level and trend model. of the institution’s IRR exposure. The Asset/Liability Committee (ALCO) or a similar senior The board or an appropriate board committee should management committee should actively monitor the IRR review sensitivity to market risk information at least profile. The committee should have sufficient quarterly. The information should be timely and of representation across major functions (e.g., lending, sufficient detail to allow the board to assess senior investment, and funding activities) that they can directly or management’s performance in monitoring and controlling indirectly influence the institution’s IRR exposure. market risks and to assess management’s compliance with board-approved policies. Policies and Procedures

In order to fulfill its responsibilities in this area, the board Policies and procedures should be comprehensive and is expected to: govern all material aspects of an institution’s IRR management process. IRR policies and procedures should: • Establish formal risk management policies, strategies, and risk tolerance levels; • Address board and senior management oversight; • Define management authorities and responsibilities; • Outline strategies, risk limits, and controls; • Communicate its risk management strategies and risk • Define general methods used to identify risk; tolerance levels to all responsible parties; • Describe the type and frequency of monitoring and • Monitor management’s compliance with board- reporting; approved policies; • Provide for independent reviews and internal controls; • Understand the bank’s risk exposures and how those • Ensure that significant new strategies, products, and risks affect enterprise-wide operations and strategic businesses are integrated into the IRR management plans; and process; • Provide management with sufficient resources to • Incorporate the assessment of IRR into institution- measure, monitor, and control IRR. wide risk management procedures so that interrelated risks are identified and addressed; and Senior Management Oversight • Provide controls over permissible risk mitigation activities, such as hedging strategies and instruments, Senior management is responsible for ensuring that board- if applicable. approved IRR strategies, policies, and procedures are appropriately executed. Management should ensure that Interest Rate Risk Strategies risk management processes consider the impact that various risks, including credit, liquidity, and operational Management should develop IRR strategies that reflect risks could have on IRR. board-approved risk tolerances and do not expose the bank to excessive risk. An institution’s risk profile is a function Management is responsible for maintaining: of the bank’s activities and products. For example, an institution’s IRR strategy may be to maintain a short-term, • Appropriate policies, procedures, and internal controls non-complex balance sheet. In order to implement that that address IRR management, including limits and strategy, management may hold loans and securities with controls that ensure risks stay within board-approved short durations and minimal embedded options and fund tolerances; the assets with nonmaturity deposits and short-term • Comprehensive systems and standards for measuring borrowings. IRR, valuing positions, and assessing performance; • Adequate procedures for updating IRR measurement Some institutions may conduct borrowing and investment scenarios and documenting key assumptions that drive transactions (leverage strategies) that are separate from the IRR analysis; and bank’s core operations. In a typical leverage strategy, • Sufficient reporting processes for informing senior management acquires short- or intermediate-term

Sensitivity to Market Risk (7/18) 7.1-4 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 wholesale funds or borrowings and invests those funds in • Net interest income, longer-term bonds. Prior to implementing a leverage • Net operating income, and strategy, management should have the skills to understand, • Net income. measure, and manage the risks. Management should be able to demonstrate a transaction’s effect on the bank’s Capital-based risk limits may include volatility risk profile and document that the exposure is within considerations involving: established risk limits. • Economic value of equity, and Management should measure and document a strategy’s • Other comprehensive income. effect on IRR exposure prior to implementation, periodically thereafter, and prior to any significant strategy The board should provide staffing resources sufficient to changes. Institutions should consider stress testing all ensure: prospective strategies and ensure IRR exposures are within established risk limits. • Effective operation of measurement systems,

• Appropriate analytic expertise, Risk Limits and Controls • Adequate training and staff development, and • Regular independent reviews. Risk limits should reflect the board’s tolerance of IRR exposure by restricting the volatility of earnings and capital for given rate movements and applicable time Risk Monitoring and Reporting horizons. Risk limits should be explicit dollar or percentage parameters. IRR exposure limits should be Management should report IRR in an accurate, timely, and informative manner. At least quarterly, senior commensurate with the complexity of bank activities, management and the board should review IRR reports. balance sheet structure, and off-balance sheet items. At a Institutions that engage in complex or higher risk activities minimum, limits should be expressed over one and two should assess IRR more frequently. At a minimum, IRR year time horizons, correspond to the internal exposure reports should contain sufficient detail to permit measurement system’s methodology, and appropriately management and the board to: address all key IRR risks and their effect on earnings and capital. • Identify the source and level of IRR; Examiners should carefully evaluate policy guidelines and • Evaluate key assumptions, such as interest rate board-approved risk limits. Institutions should establish forecasts, deposit behaviors, and loan prepayments; limits that are neither so high that they are never breached, and nor so low that exceeding the limits is considered routine • Determine compliance with policies and risk limits. and unworthy of action. Effective limits will provide management sufficient flexibility to respond to changing ← economic conditions, yet be stringent enough to prevent INTEREST RATE RISK ANALYSIS excessive risk-taking. An effective risk management system must clearly Policies should be in place to ensure excessive IRR quantify and timely report risks. Institutions should have exposures receive prompt attention. Controls should be sound IRR measurement procedures and systems that designed to help management identify, evaluate, report, assess exposures relative to established risk tolerances. and address excessive IRR exposures. Policies should Such systems should be commensurate with the require management to regularly monitor risk levels, and complexity of the institution. Although management may controls should be altered as needed when economic rely on third-party IRR models, they should fully conditions change or the board alters its risk tolerance understand the underlying analytics, assumptions, and level. Reports or stress tests that reflect significant IRR methodologies of the models and ensure such systems and exposure should be promptly reported to the board (or processes are incorporated appropriately in the strategic appropriate board committee), and the board should review (long-term) and tactical (short-term) management of IRR all risk limit exceptions and management’s proposed exposures. actions. Management should conduct careful due diligence/pre- Earnings-based risk limits may include volatility acquisition reviews to ensure they understand the IRR considerations involving: characteristics of new products, strategies, and initiatives. Management should also consider whether existing • Net interest margin, measurement systems can adequately capture new IRR

RMS Manual of Examination Policies 7.1-5 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 exposures. When analyzing whether or not a product or measurement method. Gap analysis can be a first step in activity introduces new IRR exposures, management identifying IRR exposures and may serve as a should consider that changes to an instrument’s maturity, reasonableness check for more sophisticated forms of IRR repricing, or repayment terms can materially affect a measurement, particularly in less complex institutions with product’s IRR characteristics. Institutions may be able to simple balance sheets. run alternative scenarios in their IRR models to test the effects of new products and initiatives. If an institution is Gap analysis helps identify maturity and repricing unable to run alternative scenarios using existing models, mismatches between assets, liabilities, and off-balance they should use other methods to estimate the risk of new sheet instruments. Gap schedules segregate rate-sensitive products, strategies, and initiatives. All institutions should assets (RSA), rate-sensitive liabilities (RSL), and off- ensure that the method(s) they use to evaluate new balance sheet instruments according to their repricing products and initiatives (running alternative scenarios in characteristics. Then, the analysis summarizes the existing models or through other means), adequately repricing mismatches for defined time horizons. captures potential market risks. Additional calculations can then estimate the effect the repricing mismatches may have on net interest income. Management should consider earnings and the economic value of capital when evaluating IRR. Reduced earnings A basic gap ratio is calculated as: or losses can harm capital, liquidity, and the institution’s reputation. Risk-to-earnings measurements are normally RSA minus RSL derived from simulation models that estimate potential Average Earning Assets earnings variability. Economic value of equity (EVE) measurements allow for longer-term earnings and capital Gap analysis may identify periodic, cumulative, or average analysis. The analysis may be useful for long-term mismatches, or it may show the ratio of RSA-RSL divided planning and may also indicate a need for short-term by average assets or total assets. However, using those actions to mitigate IRR exposure. Long term earnings-at- denominators does not produce a standard gap ratio. They risk simulations (5 to 7 years) can be a helpful supplement simply provide other ways of describing the degree of to EVE measures, but they are not a replacement for EVE repricing mismatches. measurements. A bank has a positive gap if the amount of RSAs repricing ← in a given period exceeds the amount of RSLs repricing INTEREST RATE RISK MEASUREMENT during the same period. When a bank has a positive gap, it is said to be asset sensitive. Should market interest rates METHODS decrease, a positive gap indicates that net interest income would likely also decrease. If rates increase, a positive gap Institutions are encouraged to use a variety of indicates that net interest income may also increase. measurement methods to assess their IRR profile. Regardless of the methods used, a bank’s IRR Conversely, a bank has a negative gap when the amount of measurement system should be sufficient to capture all RSLs exceeds the amount of RSAs repricing during the material balance sheet items and to quantify exposures to same period. When a bank has a negative gap, it is said to both earnings and capital. The most common types of IRR be liability sensitive, and a decrease in market rates would measurement systems are: likely cause an increase in net interest income. Should interest rates increase, a negative gap indicates net interest • Gap Analysis, income may decrease. While the terms asset and liability • Duration Analysis, sensitive are generally used to describe gap results, they • Earnings Simulation Analysis, can also be used to describe the results of other models, or • Earnings-at-Risk, even the general IRR exposure of a bank. • Capital-at-Risk, and • Economic Value of Equity. The gap ratio can be used to calculate the potential impact on interest income for a given rate change. This is done by Gap Analysis multiplying the gap ratio by the assumed rate change. The result estimates the change to the net interest margin. Gap analysis is a simple IRR methodology that provides an easy way to identify repricing gaps. It can also be used to For example, assume a bank has a 15 percent one-year estimate how changes in rates will affect future income. average gap. If rates decline 2 percent, then the projected However, gap analysis has several weaknesses and is impact is a 30 basis point decline in the net interest margin generally not sufficient as a financial institution’s sole IRR (15 percent x 2 percent). This estimate assumes a static

Sensitivity to Market Risk (7/18) 7.1-6 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 balance sheet and an immediate, sustained interest rate shift. Duration Analysis

Gap analysis has several advantages. Specifically, it: Duration analysis measures the change in the economic value of a financial instrument or position that may occur • Identifies repricing mismatches, given a small change in interest rates. It considers the • Does not require sophisticated technology, timing and size of cash flows that occur before the • Is relatively simple to develop and use, and instrument’s contractual maturity. Additional information • Can provide clear, easily interpreted results. on different types of duration analysis is included below and in the glossary. However, the weaknesses of gap analysis often overshadow its strengths, particularly for a majority of Macaulay duration calculates the weighted average term financial institutions. For example, gap analysis: to maturity of a security’s cash flows. Duration, stated in months or years, always: • Generally captures only repricing risk, • Assumes parallel rate movements in assets and • Equals maturity for zero-coupon instruments, liabilities, • Equals less than maturity for instruments with • Generally does not adequately capture embedded payments prior to maturity, options or complex instruments, • Declines as time elapses, • May not identify material intra-period repricing risks, • Is lower for amortizing instruments, and and • Is lower for instruments with higher coupons. • Does not measure changes in the economic value of capital. Modified duration, calculated from Macaulay duration, estimates price sensitivity for small interest rate changes. Some gap systems attempt to capture basis, yield curve, An instrument’s modified duration represents its and option risk. Multiple schedules (dynamic or scenario percentage price change given a small change in interest gap analysis) can show effects from non-parallel yield rates. curve shifts. Additionally, sensitivity factors may be applied to account categories. These factors assume that Modified duration assumes that interest rate shifts will not coupon rates will change by a certain percentage for a change an instrument’s cash flows. As a result, it does not given change in a market index. The market index is estimate price sensitivity with an acceptable level of designated as the driver rate (sophisticated systems may precision for instruments with embedded options (e.g., use multiple driver rates). These sensitivity percentages, callable bonds or mortgages). Institutions with significant also called beta factors, may dramatically change the option risk should not rely solely upon modified duration results. to measure IRR.

Institutions can also use sensitivity factors in their gap Effective duration estimates price sensitivity more analysis to refine non-maturity deposit assumptions. For accurately than modified duration for instruments with example, management may determine that the cost of embedded options and is calculated using valuation models funds for money market deposit accounts (MMDA) will that contain option pricing components. First, the user increase by 75 basis points whenever the six-month must determine the instrument’s current value. Next, the Treasury bill rate increases by one percent. Thus, valuation model assumes an interest rate change (usually management might consider only 75 percent of MMDA 100 basis points) and estimates the instrument’s new value balances as rate sensitive for gap analysis. Management based on that assumption. The percentage change between may expand its analysis by preparing gap schedules that the current and forecasted values represents the assume different market rate movements and changing instrument’s effective duration. customer behaviors. All duration measures assume a linear price/yield As noted above, gap analysis is generally not suitable as relationship. However, that relationship actually is the sole measurement of IRR for the large majority of curvilinear, which means that large shifts in rates have a institutions. Only institutions with very simple balance greater effect than smaller changes. Therefore, duration sheet structures, limited assets and liabilities with may only accurately estimate price sensitivity for rather embedded options, and limited derivative instruments and small (up to 100 basis point) interest rate changes. off-balance sheet items should consider relying solely on Convexity-adjusted duration should be used to more gap analysis for IRR measurements.

RMS Manual of Examination Policies 7.1-7 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 accurately estimate price sensitivity for larger interest rate years five, six, and seven), whereas EVE models aggregate changes (over 100 basis points). the effect of such mismatches.

Duration analysis contains significant weaknesses. Institutions may vary their simulation rate scenarios based Accurate duration calculations require significant analysis on factors such as pricing strategies, balance sheet and complex management information systems. Further, compositions, hedging activities, etc. Simulation may also duration only measures value changes accurately for measure risks presented by non-parallel yield curve shifts. relatively small interest rate fluctuations. Therefore, institutions must frequently update duration measures Institutions can run static or dynamic simulations. Static when interest rates are volatile or when any significant models are based on current exposures and assume a change occurs in economic conditions, market conditions, constant balance sheet with no new growth. The models or underlying assumptions. can also include replacement-growth assumptions where replacement growth is used to offset reductions in the Earnings Simulation Analysis balance sheet during the simulation period.

Earnings simulation models (such as pro-forma income Dynamic simulation models may assume asset growth, statements and balance sheets) estimate the effect of changes in existing business lines, new business, or interest rate changes on net interest income, net income, changes in management or customer behaviors. Dynamic and capital for a range of scenarios and exposures. simulation models can be useful for business planning and Historically, comprehensive simulation models (both long- budgeting purposes. However, these simulations are and short-term) were primarily used by larger, more highly dependent on key variables and assumptions that complex institutions. Current technology allows less are difficult to project with accuracy over an extended complex institutions to perform cost effective, period. Also, when management changes simulation comprehensive simulations of the potential impact of scenarios, it may lose insights on the bank’s current IRR changes in market rates on earnings and capital. positions. Dynamic simulations can provide beneficial information but, due to their complexity and multitude of A simulation model’s accuracy depends on the use of assumptions, can be difficult to use effectively and may accurate assumptions and data. Like any model, mask significant risks. inaccurate data or unreasonable assumptions lead to inaccurate or unreasonable results. Projected growth assumptions in dynamic modeling often alter the balance sheet in a manner that reflects reduced A key aspect of IRR simulation modeling involves IRR exposure. For example, if a liability-sensitive bank selecting an appropriate time horizon(s) for assessing IRR assumes significant growth in one-year adjustable rate exposures. Simulations can be performed over any period mortgages or long-term liabilities and the growth targets and are often used to analyze multiple horizons identifying are not met, management may have underestimated short-, intermediate-, and long-term risks. When using exposures to changing interest rates. Therefore, when earnings simulation models, IRR exposures are often more performing dynamic simulations, institutions should also accurate when projected over at least a two-year period. run static or no-growth simulations to ensure they produce Using a two-year time frame better captures the full impact an accurate, comparative description of the bank’s IRR of important transactions, tactics, and strategies, which exposure. may be hidden by only viewing projections over shorter time horizons. Management should be encouraged to Economic Value of Equity measure earnings at risk for each one-year period over their simulation horizon to better understand how risks Despite their benefits, both static and dynamic earnings evolve over time. For example, if the bank runs a two year simulations have limitations in quantifying IRR exposure. simulation, one- and two-year simulation reports should be As a result, economic value methodologies should also be generated. used to broaden the assessment of IRR exposures, particularly to capital. Longer-term earnings simulations of up to five to seven years may be recommended for institutions with material Economic value methodologies attempt to estimate the holdings of products with embedded options. Such changes in a bank’s economic value of capital caused by extended simulations can be helpful for IRR analysis and changes in interest rates. A bank’s economic value of economic value measurements. It is usually easier for an equity represents the present value of the expected cash extended simulation model to identify when long-term flows on assets minus the present value of the expected mismatches occur (e.g., it can show that a bank is liability cash flows on liabilities, plus or minus the present value of sensitive in years two, three, and four, but asset sensitive in the expected cash flows on off-balance sheet instruments.

Sensitivity to Market Risk (7/18) 7.1-8 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

Typically, an EVE model projects the value of a bank’s when possible, should be aggregated by product type, economic capital for a base-case scenario, and then coupon, maturity, and prepayment volatility. For compares it to a stress scenario. These models go by adjustable rate portfolios, modeling should include more various names and acronyms, such as EVE, MVE (Market IRR attributes, such as coupon reset dates and indexes; Value of Equity), or NPV (Net Present Value). embedded caps and floors; and prepayment penalties.

In theory, an economic valuation approach has a broader Despite being different methodologies, earnings simulation scope than an earnings approach, since it captures all and EVE models generally provide a consistent view of anticipated cash flows and is generally more effective in IRR trends. However, the two approaches may also capturing embedded options. An economic valuation generate divergent outcomes. In many cases, earnings approach measures all estimated changes to the balance simulation models provide shorter-term results and EVE sheet and earnings, as opposed to gap models and earnings models provide a much longer-term risk profile. These simulations, which generally measure shorter-term balance divergent outcomes can result from a variety of factors, sheet and earnings projections. Economic valuation such as the structure of the balance sheet, including the methods can be an effective supplement to short-term bank’s derivative positions and off-balance sheet items, the measures. interest rate environment, the timing of asset/liability mismatches, the sensitivity of funding sources to interest Many institutions can benefit from the use of economic rate changes, and the volume of fixed- or floating-rate value methods and should establish EVE risk limits and assets. Because many versions of each model type are integrate economic valuation methods into their IRR available, management should ensure that the models used measurement procedures. Because different EVE models capture all significant risk factors. calculate different base-case economic capital values for the same bank, limits should generally be based on the ← change of economic capital rather than absolute levels of STRESS TESTING economic capital. Accordingly, examiners should assess the relative changes in economic value of capital as a key Stress testing, which includes both scenario and sensitivity indication of risk. analysis, is an integral part of IRR management. Scenario analysis estimates possible outcomes given an event or Most economic value models use a static approach where series of events, while sensitivity analysis estimates the the analysis does not incorporate new business lines and all impact of change in one or only a few of a model’s financial instruments are held until final payout or significant parameters. maturity. The analysis shows a snapshot of the risk inherent in a portfolio or balance sheet. However, this is Management should assess a range of alternative interest not always the case as some models incorporate dynamic rate scenarios when conducting scenario analyses. The techniques that provide forward-looking estimates of range should be sufficient to fully identify repricing, basis, economic value. and yield curve risks as well as the risk of embedded options. In many cases, static interest rate shocks Because EVE estimates the future cash flows of the bank’s consisting of parallel shifts in the yield curve of only plus financial instruments, the cash flows can be difficult to and minus 200 basis points are not sufficient to adequately accurately quantify. This can be especially true for non- assess IRR exposure. Therefore, management should maturity deposits since the products generally have regularly assess a wide range of exposures across different uncertain cash flows and durations. Consequently, periods, including changes in rates of greater magnitude estimating the value of these accounts can be difficult and (e.g., up and down 300 and 400 basis points). When requires the use of several assumptions. Management conducting stress tests, management should give special should be cautious when making EVE assumptions, as consideration to financial instruments or markets where output errors can be more pronounced in long-term concentrations exist, as such positions may be difficult to measurements. Examiners should consider the unwind or hedge during periods of market stress. significance, accuracy, and sensitivity of underlying Management should compare stress test results against assumptions when assessing EVE models. approved limits.

When modeling complex products with embedded options, Management should ensure their scenarios are rigorous the importance of data aggregation and stratification and consistent with the existing level of rates and the should not be overlooked. Complex or structured interest rate cycle. For example, in low-rate environments, securities should be modeled on an individual basis, and scenarios involving significant declines in market rates can homogenous balance sheet accounts should be aggregated be deemphasized in favor of increasing the number and by common IRR features. For example, loan portfolios, size of alternative rising-rate scenarios. Alternatively,

RMS Manual of Examination Policies 7.1-9 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 there may be instances where more extreme stress tests ← would be desirable. INTEREST RATE RISK MEASUREMENT SYSTEMS Depending on a bank’s IRR profile, stress scenarios should include: The IRR measurement system should be appropriate for

institution’s risk profile. The measurement system should • Instantaneous and significant rate changes, capture all material sources of IRR and generate • Substantial rate changes over time, meaningful reports for senior management and the board • Changes in the relationships between key market of directors. Management should ensure risks are rates, and measured over a relevant range of interest rate changes, • Changes in the shape or slope of the yield curve. including meaningful stress situations. Further, the measurement system must be subject to appropriate Not all financial institutions need to use the full range of internal controls and periodic independent reviews. The the scenarios discussed above. Non-complex institutions IRR measurement process should be well documented and (for instance, institutions with limited embedded options or administered by individuals with sufficient technical structured products) may be able to justify running fewer knowledge. or less intricate scenarios. IRR measurement systems can range from simple methods Management should run repricing risk scenarios regularly. to sophisticated programs that include stochastic data When applicable, institutions should also run scenarios for modeling. (Stochastic modeling involves using one or other IRR risks, such as basis and yield curve risks. more random variables in a model.) However, all Institutions should assess these risk exposures at least measurement systems should use generally accepted annually or when the risk profile of a bank changes, for financial concepts and risk measurement techniques and example, because of acquisitions, significant new products, have an adequate level of transparency. If a third-party or new hedging programs. If a bank shows material model is used, management should review the adequacy exposure to one of these risks, an appropriate scenario and comprehensiveness of the vendor’s model-validations should be included in monthly or quarterly IRR and internal control reviews. Also, management should monitoring. If an institution has relatively non-complex consider the capabilities of the software to meet the exposure to basis, yield curve, or options risk, management institution’s future needs and the adequacy of ongoing should document that the exposure is minimal. For vendor support and training. example, management may document its assessment with a short narrative description of what percentage of assets A bank’s IRR measurement system is a critical part of its and liabilities are tied to various indices and a description overall risk management process. Examiners rely heavily of the potential impact of the risks. These reports should on the output of the measurement systems when assessing typically be reviewed by the board at least annually. sensitivity to market risk. Accordingly, the review of such systems and their operation is a crucial element of the Sensitivity analysis should be included in stress testing to examination process. The review process should address help determine which assumptions have the most influence the following items: on a model’s output. By identifying key assumptions, management, when necessary, can refine the assumptions • Capabilities of the measurement system, to increase the accuracy of their models. The most • Accuracy of system inputs, significant variables can be tested by keeping all other • Reasonableness and documentation of material variables constant, changing the variable in question, and assumptions, comparing the results to the base-case scenario. • Usefulness of system output/reports, and Additionally, sensitivity analysis can be used to determine • Adequacy of periodic variance analysis. the conditions under which key business assumptions or model parameters break down or when IRR may be exacerbated by other risks or earnings pressures. When Measurement System Capabilities management includes assumptions based on strategic initiatives, it is imperative that they assess the impact of The IRR measurement system should capture and reliably not meeting projections. (Refer to Sensitivity Testing - estimate all material risk exposures. Therefore, the system Key Assumptions for more details.) should consider all significant balance sheet categories, income statement items, and risk factors. For example, if an institution has material holdings of mortgage loans or mortgage-backed securities, then its measurement system should be able to adequately incorporate prepayment

Sensitivity to Market Risk (7/18) 7.1-10 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 projections. Likewise, if the bank has a mortgage banking that input data, such as general ledger balances and operation that generates material fee income, its system contractual terms, are accurately captured. Institutions should capture the rate sensitivity of this noninterest should verify system inputs by having experienced income. personnel reconcile the balances to the general ledger. This is often done using automated software that can When an institution develops an IRR model internally or identify and report exception items. considers acquiring a third-party model, management should assess its suitability by evaluating the model’s In addition to capturing account balances, institutions with ability to reasonably capture all relevant and material IRR complex balance sheets should use measurement systems exposures. Additionally, management should periodically that adequately capture the embedded market risk of all re-evaluate the adequacy of a model in use as risk material on- and off-balance sheet activity. Most positions, strategies, and activities change. measurement systems allow for the input of the following contractual terms: To effectively use its IRR measurement system, management must fully understand the system’s • Current balance, capabilities, limitations, quantitative methodologies, and • Contractual maturities, use of assumptions. • Principal and interest payments and frequencies, • Coupon rates and repricing frequencies, System Documentation • Contractual caps and floors, and • Contractual optionality (such as security or borrowing Both purchased and internally developed systems should calls). be supported by adequate documentation. System documentation should provide complete information Account Aggregation regarding the factors discussed above. Management should be familiar with and retain all pertinent system Account aggregation is the process of grouping together documentation. Management should also review and accounts of similar types and cash flow characteristics. maintain documentation of changes or upgrades to the This is an important component of the data input process model. as account aggregation improves the measurement system’s efficiencies. Typically, loans of similar rate, Adequacy of Measurement System Inputs maturity, and type (e.g., 6 percent, 30 year, residential loans) are aggregated. Grouping 6 percent, 30 year A model’s accuracy depends on the assumptions and data residential loans together may be appropriate, but grouping used. Like any model, inaccurate data or unreasonable together 6 percent fixed-rate loans with 6 percent assumptions will render inaccurate results. adjustable-rate loans is not.

System data should accurately reflect the bank’s current The degree of account aggregation will vary from one condition. When evaluating the adequacy of a model, institution to another. Institutions should ensure the model management should consider the extent to which the allows for a sufficient separation of accounts with model uses automated versus manual processes; whether significantly different cash flow patterns. For example, the model has automated interfaces with the bank’s core models that aggregate information based on Call Report systems; and the funds, hardware, staff, and expertise data may not provide the granularity necessary for needed to run and maintain the model. institutions with significant levels of embedded options. When applicable, institutions should ensure their systems Examination of the system’s input process should focus on have the ability to model highly structured instruments and the procedures for inputting and reconciling system data, bank-specific products. categorizing and aggregating account data, ensuring the completeness of account data, and assessing the Both contractual and behavioral characteristics should be effectiveness of internal controls and independent reviews. considered when determining the cash flow patterns of accounts to aggregate. The process of determining which The internal control process must be comprehensive accounts are combined should be transparent, documented, enough to ensure that data inputs are accurate and and periodically reviewed. Furthermore, requests for complete prior to running the system and generating changes to existing groups or new account aggregations reports. The bank may input data manually, through data- should be formalized and documented. Institutions should extract programs, or a combination of both techniques. maintain documentation disclosing the characteristics of Internal control procedures should be established to ensure

RMS Manual of Examination Policies 7.1-11 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 aggregated assets and liabilities (including all derivative could alter its non-maturity deposit beta assumptions instruments), and off-balance sheet items. incrementally (up and down) in multiple scenarios (e.g., a 10, 25, and 50 percent increase/decrease from the base- Assumptions case assumption). The revised results could then be compared to the base-case scenario. If a change in the Assessing the reasonableness of assumptions is a critical assumption disproportionately impacts the model, then part of reviewing an IRR measurement system. It is management should implement more robust assumption important that assumptions accurately reflect documentation, monitoring, and testing. Another sound management’s expectations regarding interest rates, practice when testing assumptions is to determine how customer behaviors, and local and macro-economic extreme changes in key assumptions impact results and factors. Assumptions are typically derived using a whether the results approach approved tolerance levels. combination of internal analysis and external sources. All material assumptions should be regularly updated and Conducting sensitivity testing on an annual basis is usually supported with thorough analysis and documentation. adequate for many institutions. However, more frequent tests should be performed if concerns are identified. IRR measurement systems rely on assumptions regarding Institutions should document the results of sensitivity key parameters, such as: testing and present the results to management and the board. The results of sensitivity testing should be • Projected interest rates, considered when setting various assumptions. • Driver rate relationships, Management should conduct thorough due diligence • Non-maturity deposits, and before changing key assumptions that can materially alter model results. Key assumption changes should be • Prepayments. properly documented and reviewed by the board.

It is important that material assumptions be updated Projected interest rate assumptions are a critical part of regularly to reflect the current market and operating measuring IRR and may be generated by internal analysis environment. Furthermore, the process for developing or external sources. Internal interest rate forecasts, which material assumptions should be formalized and may be derived from implied forward yield curves, periodically assessed (at least annually for critical economic analysis, or historical regressions, should be assumptions). This periodic assessment of the information documented to support the assumptions used in the and processes used to generate assumptions may prompt analysis. Key rate assumptions that should be considered management to reevaluate its assumptions in order to include assumptions for general market rates, repricing better reflect current strategies or customer behaviors. rates, replacement interest rates, and discount rates.

Sensitivity Testing - Key Assumptions Most institutions perform scenario analysis using deterministic interest rate yield curves. With the Proper IRR management requires an understanding of deterministic method, all interest rate scenarios are set by which assumptions have the greatest impact on results. the user; that is, management selects the interest rate Through sensitivity testing, management can identify the changes to simulate in the model. The deterministic assumptions that have the most effect on model results. method differs from the more complex and sophisticated Documentation and monitoring should reflect the relative stochastic method where multiple scenarios are generated importance of assumptions. Sensitivity testing can also be using random path-dependent variables. (Further used to identify less material assumptions, where discussion of deterministic and stochastic methods may be assumption documentation, monitoring, and testing are found in the glossary.) less critical. Sensitivity testing can also be used to identify weaknesses in the model. For example, if an institution Analysis should be performed using a base-case interest tested an assumption that was expected to have a critical rate scenario, as well as low-probability/high-risk impact on the model result, but instead found that it had scenarios, so that management can better estimate the little or no influence on the model output, further impact to earnings and capital levels in stressed interest investigation would be warranted. rate scenarios. The base-case interest rate scenario should be consistent with other forecasts used in the bank’s Sensitivity testing should only be applied to one overall planning process and should remain reasonably assumption at a time and should test the effects of both consistent across reporting periods. Any changes in the large and small changes in an assumption on the model’s source of interest rate forecasts between reporting periods overall output. For example, if an institution wanted to should be justified and documented. test the sensitivity of non-maturity deposit decay rates, it

Sensitivity to Market Risk (7/18) 7.1-12 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

Driver rates are used extensively in most income correlation analysis, but also to management’s intentions simulation and EVE models. The models capture the regarding future rate movements. If the measurement relationship between primary market interest rates (driver system has the capacity to reflect different assumptions for rates) and the rates of bank products. While there may be rising and falling rates, management should establish rate no direct connection between bank rates and the driver sensitivity assumptions for both scenarios. rate, the driver rate is chosen as a proxy for management’s reaction to market changes. This frees management from Non-maturity deposits present a unique problem in EVE needing to set rates explicitly for each loan or deposit type modeling because they lack contractual maturity dates. for each projected scenario. In most cases, bank rates are Generally an asset or liability must have a maturity date in set to move in relation to the driver rate. The move may order to be valued under present value methods. be referred to as a spread (when a specified number of Therefore, in order to successfully model these accounts, basis points are added to or subtracted from a driver rate), an EVE model must use management’s assumptions or as a beta factor (when based on a percentage change in a regarding the maturity of the accounts. The most common driver rate). For example, management might specify that of these assumptions is the decay rate assumption. The the rate paid on MMDAs will increase 75 basis points if decay rate reflects the amount of nonmaturity (and other) the yield on one-year Treasury bills increases 100 basis deposits that may be withdrawn or accounts closed in a points. By designating this relationship, pricing on all given rate environment. products linked to the driver rate will change to reflect the relationship built into the model. More complex systems Management should use NMD assumptions that reflect may use a variety of driver rates tailored for different institution-specific factors and avoid overreliance on products. While most systems maintain static rate industry estimates or default assumptions contained in off- relationships, more sophisticated systems can alter the-shelf IRR models. Some institutions have difficultly relationships for different interest rate environments. measuring decay rates on NMDs due to limited historical data, acquisitions, mergers, or a lack of technical expertise. Spread or beta assumptions should be based on an analysis Industry averages provide approximations, but are often of the relationship between the product (e.g., MMDA) and not the most accurate estimates because they are not the driver rate (e.g., federal funds rate). To determine the tailored to the bank’s products, pricing strategies, market, spread or beta, management can perform correlation or and experience. However, management can use industry regression analysis to quantify the historical relationship estimates as a starting point until they develop adequate between the product and driver rates. data sets. Industry estimates can also serve as a benchmarking tool to test the reasonableness of internal Correlation analysis may also be used to determine the assumptions. Management should consider modeling level of basis risk when instruments are tied to different different decay rates under various rate scenarios and, indices. For instance, if an institution enters into a when appropriate, should consider engaging third parties leveraging strategy that uses borrowed funds tied to to assist in determining NMD assumptions. Examiners LIBOR to invest in U.S. Treasury securities, correlation should recognize that NMD decay rate are often imprecise, analysis can be performed to determine how closely the yet significant factors in IRR analysis. related rates move together. Less correlated instruments present greater basis risk. Assumptions regarding NMDs are particularly critical in market environments in which customer behaviors may be Non-maturity deposit (NMD) rate sensitivity is typically atypical, or in which institutions are subject to heightened one of the most critical and most difficult assumptions that competition for such deposits. Generally, rate-sensitive management makes when measuring IRR exposure. The and higher-cost deposits, such as brokered and Internet potential actions of management and customers need to be deposits, reflect higher decay rates than other types of considered. Just as customers have control over the level deposits. Also, institutions experiencing or projecting and location of their deposit accounts, management has lower capital levels that may trigger brokered and high broad control over the rates paid on these accounts. In interest rate deposit restrictions should adjust deposit setting rates, management must take into account a wide assumptions accordingly. array of factors, including local and national competition, the bank’s funding needs, and the relative costs of Prepayment assumptions are important considerations alternative funding sources. when measuring optionality risk. Prepayment risk (or conversely, extension risk) on loans and mortgage-related The assumptions modeled for NMDs should reflect both securities are highly influenced by the direction of interest aspects of this relationship: management’s control over rates. Prepayment assumptions may also be affected by rates and customers’ control over their funds. factors such as loan size, geographic area, credit score, and Consideration should be given not only to historical fixed versus variable rates. It is critical that assumptions

RMS Manual of Examination Policies 7.1-13 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 be reasonable for each rate scenario measured. For Assumption summary reports are an important tool that example, in an increasing rate environment, prepayment management and examiners can use to ensure that assumptions should typically reflect lower prepayments reasonable assumptions have been entered into the than in a declining rate environment. measurement system. The reports can also be useful to examiners when management does not maintain adequate Financial institutions may actively track internal documentation of current assumptions. For example, when prepayment data or obtain prepayment statistics from assumption summary reports are regularly produced and external sources. Management should consider the retained, examiners can compare current assumptions reliability and applicability of external data and be against historical assumption reports. cognizant that market stress, externalities, or a change in the institution’s condition may influence customer To ensure proper controls over significant assumption behaviors. changes, management should establish procedures for reviewing the reasonableness of assumption changes and Management should ensure that assumptions are for approving those changes before they occur. appropriate given the characteristics of the institution’s various portfolios (i.e., prepayment speeds for a portfolio Measurement System Results of five percent loans would likely differ from a portfolio of eight percent loans). In addition, proper aggregation of the After data and assumptions have been input, the IRR assets is necessary before applying assumptions. measurement system performs calculations. The Documentation and support of all significant assumptions, calculations measure the IRR in the bank’s assets, including projected rates, spreads, customer behaviors, and liabilities, and off-balance sheet items. The measurement NMD rates should be maintained and available for system should generate summary reports that highlight the examiner review. Some measurement systems have only bank’s sensitivity to changes in market rates given various limited ability to change model assumptions, in which case interest rate scenarios. These reports typically indicate the documentation may be limited. Even in those cases, an change in net income or net interest income and/or analysis of the applicability of the embedded assumptions economic value of equity. Some systems may also provide to the subject bank should be performed and maintained. a gap report highlighting asset/liability mismatches over More complex systems entail a vast array of assumptions, various time horizons. More detailed reports may be and thorough documentation of every assumption cannot available on some systems that can be used to test the be realistically expected. However, management should reasonableness, consistency, and accuracy of the output. thoroughly support and document assumptions related to They may also assist the examiner in identifying or the most significant institution or model risks. verifying the system’s underlying assumptions.

Measurement System Reports Management should have formalized procedures in place for reviewing measurement system results and reporting to Many measurement systems are capable of providing the board or a board committee. Reports provided to the summary reports detailing key model assumptions. board and senior management should be clear, concise, Examiners should review a copy of these reports when timely, and informative in order to assist the board and analyzing a measurement system. senior management in making decisions. The results of the measurement system should also highlight deviations Most asset/liability management systems offer an array of from board-approved IRR exposure limits. Examiners summary reports (such as a chart of accounts and account should review follow-up actions and communication attribute reports) that aid management in reviewing relevant to any material breaches in board-approved limits. measurement system assumptions. These reports may also Examiners should also review the presentations or analyses provide information regarding the contractual terms and provided to senior management, board members, and the parameters that have been entered into the system for ALCO, as well as any relevant meeting minutes. various account types and financial instruments. Variance Analysis If an institution is unable to provide assumption summaries, examiners should determine whether the Variance analysis (also known as back-testing) can provide absence of the report is due to measurement system valuable insights into the accuracy and reasonableness of limitations or bank personnel’s lack of familiarity with IRR models and is an integral part of the control process system capabilities. Typically, measurement system user for IRR management. Variance analysis involves manuals will provide a list of reports that may be identifying material differences between actual and generated by the system. forecasted income statement and balance sheet amounts

Sensitivity to Market Risk (7/18) 7.1-14 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 and ascertaining the causes of the differences. Variances assumptions should be compared to actual performance. can be readily identified by direct comparison of the Compensating differences may have masked important financial statements for a particular forecast period, or by variances. For example, an institution with a large using key financial indicators, such as net interest margin, mortgage portfolio may find that actual prepayment speeds cost of funds, or asset-yield comparisons. were significantly higher than projected, but new loan production replaced the run-off. In this case, there may Variance analysis can help management understand the only be an immaterial variance in the ending loan balance, primary reasons for material differences between projected but a significant variance in projected vs. actual and actual results. It can also provide a means to improve prepayments. the precision of the IRR measurement system. Periodic variance analysis helps assure management and the board Given the large number of assumptions inherent in most that the system is accomplishing its primary goal of measurement systems, a thorough review of every providing meaningful information on the level of IRR. assumption during each measurement cycle is unrealistic. Variance analysis provides an opportunity for a deeper However, key assumptions should be checked against understanding of both the system and its results. actual behaviors on a regular basis. Key assumptions include those dealing with interest rate movements, driver Variance analysis should be done periodically and no less rates, non-maturity deposits, prepayment speeds, and frequently than annually. Further, management should account aggregations. Variance analysis should be used to document their analysis, highlighting any material identify the differences attributable to rate assumptions and variances, the primary cause of identified variances, and other factors in order to better understand how those any proposed or implemented corrective actions. factors influenced modeled results.

Variances resulting from errors can be broken down into Driver rate variances occur when the expected correlation three major components: input, modeling, or assumption between a bank rate and its driver rate does not act as errors. When conducting variance analysis, management predicted. Variance analysis is used to determine the should attempt to pinpoint the cause of all material significance of the difference and should address whether variances. Mathematical flaws, while relatively rare in the difference is due to an inaccurate correlation between widely available purchased systems, can occur. Other the subject and driver rate, or due to inappropriate spreads types of modeling errors can be caused by inaccurate data or beta factors. Ideally, the relationship between subject input, user unfamiliarity with the model, over-aggregation and driver rates should be documented, and the of account types, or the use of a model with insufficient relationship should factor in historical correlations and capabilities. management’s intentions regarding future movements.

Data errors can be minimized by strong internal controls Non-maturity deposit assumptions may cause significant and may be identified through selective transaction testing. variances. If the measurement system forecast an Many models can compare the results of historical IRR increasing net interest margin in a rising rate environment, simulations with actual financial results. Significant while the actual margin declined, the cause may involve variances can help management identify, and subsequently NMD assumptions. Many models treat NMD rates as very correct, identified issues with the model setup, such as insensitive to yield curve changes, while actual practices inappropriate account aggregations or the failure to include are to manage the rates more actively. This can lead to key account characteristics. model measurements that show the bank as asset sensitive or neutral, when past performance shows it to be liability Assumption Variance Analysis sensitive. Periodic variance analysis may identify this discrepancy and allow management to more effectively use All IRR measurement systems rely heavily on a series of the IRR measurement tool. Note: Examiners should assumptions, and assessing their reasonableness is critical recognize that models are forward looking; therefore the to ensuring the integrity of the measurement system usefulness of historical variance analysis may be limited. results. Just as actual financial results can be expected to vary from forecasts, the assumptions that form the basis of Prepayment speed variances occur when actual that forecast can be expected to vary from actual events. prepayments do not mirror those projected. Variances are not uncommon as the cash flows are difficult to model and Institutions should have formalized procedures for predict; however, management should monitor periodically identifying material differences between prepayments and revise related assumptions if material assumed and realized values. Formal procedures help variances occur. identify the key reasons for variances. Even if material Inappropriate account aggregation can also lead to financial variances are absent, the model’s significant significant variances. For example, when comparing

RMS Manual of Examination Policies 7.1-15 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 actual and modeled loan interest income, an institution may find that the model overestimated income in a falling Foreign exchange, commodities, and equity trading rate environment because real estate loans with requires a high level of technical and managerial expertise. significantly different prepayment characteristics were The risk management and measurement systems needed to aggregated together. operate them effectively are likewise highly sophisticated and require rigorous monitoring and testing. Foreign Many models measure static IRR, that is, what would exchange, commodity, or equity speculation, absent the happen to the current balance sheet if only interest rates necessary controls and sufficient capital, might be changed. Other models incorporate management considered an unsuitable practice. When necessary, projections about asset and liability growth and changes in contact legal counsel or capital markets specialists in your product mix. Variance analysis in the latter instance is region for additional guidance. complicated by the need to segregate variances due to balance sheet changes from those caused by rate Interest Rate Risk Mitigation movements. Institutions can use several measures to mitigate IRR ← exposures. If risk measures fall outside approved tolerance OTHER RISK FACTORS TO CONSIDER guidelines and trigger corrective steps (which should be guided by approved policies), management might alter Although IRR is the principal market risk taken by most their balance sheet or engage in hedging activities. financial institutions, other activities can significantly Hedging strategies often involve using complex derivative increase (or reduce) a bank’s exposure and sensitivity to instruments and are not suitable for institutions lacking market risk. technical expertise. When any IRR mitigation strategy is considered, management should also consider other risks, Foreign exchange activities expose institutions to the such as credit, liquidity, and operational risks. price (exchange rate) risk that results from volatile currency markets. Exchange rates depend upon a variety When implementing IRR mitigation techniques, the board of global and local factors that are difficult to predict, and management should ensure that policies and approved including interest rates, economic performance, central strategies address: bank actions, and political developments. • Analysis of market, liquidity, credit, and operating Commodity activities involve using commodity contracts risks; (including futures and options) to speculate or hedge. • Qualifications of personnel involved in implementing Commodity prices depend upon many factors and are very and monitoring hedging strategies; difficult to forecast. • Permissible strategies and types of derivative contracts; Generally, institutions should only use foreign exchange or • Authority levels and titles of individuals approved to commodity activities to hedge or control specific market initiate hedging transactions and related authority risks. Management, independent of the broker/dealer, limits; should demonstrate expertise commensurate with the • Risk limits for hedging activities such as position activities undertaken. In addition, management should limits (gross and net), maturity parameters, and produce documented analysis that clearly details the counterparty credit guidelines; effectiveness of all foreign exchange and commodity • Monitoring requirements for hedging activities, hedging activities. The analysis should be prepared at including ensuring activities fall within approved least quarterly and presented to the board for its review. limits and management lines of authority; and Note: Typical commodity hedging activities are • Controls for ensuring management’s compliance with significantly different from speculative commodity technical accounting guidance that covers hedging activities. activities.

Equity trading and investing creates market risk Institutions should not use derivative instruments for exposure because changes in equity prices can adversely hedging (whether or not hedge accounting is applied), affect earnings and capital. The board and management unless the board and senior management fully understand have a responsibility to identify, measure, monitor, and the institution’s strategy and the potential risks and control trading risks. Management should carefully benefits. Relying on outside consultants to assist with a monitor all equity investments, regularly evaluate the hedging strategy does not absolve the board and senior resulting market risk exposure, and provide timely reports management of their responsibility to understand and to the board.

Sensitivity to Market Risk (7/18) 7.1-16 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 oversee the risks of the activities. Hedging strategies the pools, rather than matching the specific cash flows. should be designed to limit downside earnings exposure or Duration matching is not a perfect strategy and may result manage income or EVE volatility. Activities conducted in imperfect hedging from a cash flow perspective and can solely to generate additional income should not be cause exposure to different kinds of risk (such as yield considered hedging. curve and basis risk).

Altering the balance sheet is the most common method Derivative instruments are available to hedge IRR. These institutions use to modify their IRR position. However, instruments include, but are not limited to, swaps, this strategy may take time to implement and often cannot amortizing swaps, basis swaps, futures, forwards, caps, quickly correct significant exposures. For example, if a options, floor options, and collars. The most common bank is liability sensitive and therefore exposed to rising derivatives used to hedge IRR are swaps and forwards. In interest rates, management may decide to reduce their a pay-fixed swap transaction, a stream of fixed interest retention of 30-year fixed-rate mortgages. Strategies may payments from a commercial loan may be contractually include increased sales (possibly for securitization) of exchanged for a stream of floating-rate payments. This longer-term mortgage products or pricing longer-term swap effectively shortens the duration of the commercial mortgages above market rates in order to reduce the loan portfolio by reducing the asset/liability mismatch and volume of new loan originations. While this strategy may improves profitability in a rising-rate environment. reduce IRR over time, this method can be slow in Conversely, the bank could lengthen the effective duration correcting material IRR imbalances and may not effect a of its floating-rate deposits by entering into a swap where a timely reduction in risk exposures. floating-rate stream of payments is exchanged for a fixed- rate payment stream. Institutions may also attempt to address exposures to rising interest rates by increasing longer-term deposit or Institutions that use hedging activities should understand borrowing levels. However, several factors may hinder the the true impact of a hedge (whether it actually decreases success of such strategies. There may be significant risks), and understand its impact on earnings and capital. competition or limited demand for longer-term time All derivatives require fair value accounting adjustments, deposits, and access to longer-term wholesale funding may which may result in earnings and capital volatility. While be limited or offered on unfavorable terms. Additionally, management may utilize hedges to reduce certain risks in embedded options (e.g., calls and step-up dates) in their portfolio, analysis of the hedges should consider the wholesale funding sources can present measurement impact of related accounting adjustments on earnings and challenges, and the cost of such funding can make this capital. approach prohibitive unless there is a clear productive use for the funds. Each institution using derivatives should establish an effective process for managing related risks. The level of Cash flow matching and duration matching are two formality in this process should be commensurate with the typical hedging strategies. The goal of these strategies is activities involved and the level of risk approved by senior to change a bank’s IRR exposure to meet specific cash management and the board. flow or duration targets. These strategies can be accomplished by altering the balance sheet composition or ← through the use of derivatives. INTERNAL CONTROLS

Some institutions refer to cash flow matching as matched Establishing and maintaining an effective system of funding. The bank matches the terms (rate or maturity) of internal controls and independent reviews is critical to the funding and assets so that cash flows will reprice or mature risk management process and the general safety and simultaneously and interest rate changes will not soundness of the bank. Institutions should have adequate significantly influence net cash flow. Cash flow matching internal controls to ensure the integrity of their IRR can be difficult for small institutions due to the wide range management process. These controls should promote of cash flows in most financial assets. reliable financial reporting and compliance with internal policies and relevant regulations. Internal control policies With a duration matching strategy, management may and procedures should address appropriate approval attempt to match the duration of a pool of assets with the processes, adherence to exposure limits, reconciliations, duration of a pool of liabilities. The use of interest rate reporting, reviews, and other mechanisms designed to derivatives or options might also be used to modify or provide a reasonable assurance that the bank’s IRR offset the duration of an existing pool of assets or management objectives are achieved. Internal control liabilities. The goal is to match the effective durations of policies and procedures should clearly define management the pools in order to limit the net changes in fair values of authorities and responsibilities and identify the individuals

RMS Manual of Examination Policies 7.1-17 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 and committees responsible for managing sensitivity to However, subject to board approval, it is acceptable for market risk. another department of the bank, separate from the group that measures IRR, to define, perform, and document the A sound control environment should also ensure adequate independent review. A bank’s review processes should separation of duties in key elements of the risk meet the following minimum standards: management process to avoid potential conflicts of interest. Institutions should have clearly defined duties • Independence - Parties performing the independent that are sufficiently independent from position-taking review should not be involved in the day-to-day IRR functions of the bank. Additionally, IRR exposures should measurement/management process. Institutions may be reported directly to senior management and the board of use internal staff, an outsourcing arrangement, or a directors. The nature and scope of such safeguards should combination of the two to independently review the reflect the type and structure of the bank, the volume and measurement system. Management may find that the complexity of IRR incurred by the bank, and the internal audit department, or other staff independent of complexity of its transactions and commitments. More the measurement system, has the knowledge and skills complex institutions should have an independent unit to perform certain aspects of the review while using responsible for the design and administration of the bank’s external resources for other areas. When the IRR measurement, monitoring, and control functions. assessment of the measurement system is outsourced, senior management and the board should ensure that Independent Reviews the procedures used meet the same standards required of a satisfactory internal review. Regular independent reviews of its IRR management • Skills and Knowledge - Senior management and the process are an important element of a bank’s internal board must ensure that individuals performing the control system. Internal reviews of the IRR measurement independent review have the knowledge and skills to system should include assessments of the assumptions, competently assess the measurement system and its parameters, and methodologies used. Such reviews should control environment. seek to understand, test, and document the current • Transparency - The procedures used in the measurement process, evaluate the system’s accuracy, and independent review of the measurement system should recommend solutions to any identified weaknesses. The be clearly documented, and work papers should be independent review should be tailored to the type and available to management, auditors, and examiners for complexity of an institution’s activities and encompass the review. Senior management should ensure that they standards and desirable scope discussed below. have access to work papers even when external parties Regardless of the depth of the independent review, the perform the review. findings of the review should be reported to the board no • Communication of Results - Procedures should be less frequently than annually, along with a summary of the established for reporting independent review findings bank’s IRR measurement techniques and management at least annually to the board or board-delegated practices. committee.

Independent Review Standards Scope of Independent Review

The purpose of an independent review is to ensure that the Independent reviews provide a way to assess the adequacy IRR measurement and management processes are sound. of a bank’s IRR measurement system. The level and depth Regardless of whether the review is performed by internal of the independent reviews should be commensurate with staff or external entities, it is important these parties be the bank’s risks and activities. More complex institutions independent of any operational responsibility for the should have a more rigorous independent review process. measurement and management processes. They should not Less complex institutions may rely upon less formal perform any of the routine internal control functions such reviews. At a minimum, each institution should have as reconciling data inputs, developing assumptions, or procedures in place to independently review the input performing variance analysis. process, assumptions used, and system output reports.

Independent reviews should be performed at least System-input reviews should evaluate the adequacy and annually. The scope, responsibility, and authority for the appropriateness of: reviews should be clearly documented and encompass all material aspects of the measurement process. The scope of • The knowledge and skills of individuals responsible the independent review should generally be defined by the for input to the measurement system; internal audit staff and approved by the audit committee. • The reconciliation of the measurement system’s data

Sensitivity to Market Risk (7/18) 7.1-18 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

to the bank’s general ledger; use may be problematic. Such disclosures, exclusive of • The rules and methods of account aggregation used in confidential or proprietary information, should contain the measurement system; useful insights regarding a model’s functionality and • The accuracy of contractual terms captured within the outputs. However, a certification or validation report from measurement system; and a vendor is only one component of a bank’s independent • The source, completeness, accuracy, and procedures review and should not be used as a substitute for an overall for external data feeds. validation review. Management is still responsible for any aspect of the process under their control, such as data Assumption reviews should evaluate the following issues: input, assumption changes, etc.

• The process of developing assumptions for all As part of the validation process, management should material asset, liability, and off-balance sheet ensure that the software and mathematics of the IRR model exposures; function as intended. Many community institutions use • The process for reviewing and approving key largely standardized, vendor-provided models. In such assumptions; cases, the validations provided by vendors can be used to • The periodic review of assumptions for relevance, support the accuracy of the model. For models that are applicability, and reasonableness; and customized to an individual institution or in situations where vendors are unable or unwilling to provide • The completeness of assumption analysis and its supporting documentation. appropriate certifications or validations, management is responsible for validating the accuracy of the model’s System output and reporting assessments should include mathematics and soundness of the software. coverage of the following: Additionally, vendor models may be customized by an institution for its particular circumstances. Management • Inclusion of a sufficiently broad range of potential rate should document and justify the institution’s customization scenarios, choices as part of the validation process. If vendors • Accuracy of the IRR measurement and assurance that provide input data or assumptions, their relevance to the all material exposures are captured, bank’s situation should be evaluated and approved. • Timeliness and frequency of reporting to management Institutions should obtain information regarding the data and the board, (e.g., vendor-derived assumptions) used to develop the • Compliance with operating policies and approved risk model and assess whether the data is representative of the limits, institution’s situation. • Performance and documentation of variance analyses (back-testing), and Complex institutions or those with significant IRR • Translation of model output into understandable exposures may need to perform more in-depth validation management reports that support decision making. procedures of the underlying mathematics. Validation practices could include constructing a similar model to test Theoretical and Mathematical Validations assumptions and outcomes or using an existing, well- validated benchmark model, which is often a less costly The degree to which calculations in an IRR model should alternative. The benchmark model should have theoretical be validated depends on the complexity of an institution’s underpinnings, methodologies, and inputs that are very activities and IRR model. The complexity of many close to those used in the model being validated. More measurement systems demands specialized knowledge and complex institutions have used benchmarking effectively skills to verify the mathematical equations. Less complex to identify model errors that could distort IRR institutions using simpler, vendor-supplied IRR models measurements. The depth and extent of the validation can satisfy some, but not all, validation requirements with process should be consistent with the degree of risk independent attestation reports from the vendor. exposures.

Management should periodically discuss with vendors Model certifications and validations commissioned by what validation and internal control process assessments vendors can be a useful part of an institution’s efforts to have been conducted. The vendor should provide evaluate the model’s development and conceptual documentation showing a credible, independent third party soundness. Although many vendors offer services for has performed such assessments. Vendors should be able process verification, benchmarking, or back-testing, the to provide appropriate testing results to show their product services are usually separate engagements. Each works as expected. They should also clearly indicate the institution should ensure these engagements meet its model’s limitations, assumptions, and where the product’s

RMS Manual of Examination Policies 7.1-19 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 internal policy requirements for validations and position will be adversely affected. Risk management independent reviews. practices are satisfactory for the size, sophistication, and market risk accepted by the institution. The level ← of earnings and capital provide adequate support for EVALUATING SENSITIVITY TO the degree of market risk taken by the institution. MARKET RISK 3. A rating of 3 indicates that control of market risk

sensitivity needs improvement or that there is The sensitivity to market risk component reflects the significant potential that the earnings performance or degree to which changes in interest rates, foreign exchange capital position will be adversely affected. Risk rates, commodity prices, or equity prices can adversely management practices need to be improved given the affect a financial institution’s earnings or economic size, sophistication, and level of market risk accepted capital. When evaluating this component, consideration by the institution. The level of earnings and capital should be given to: management’s ability to identify, may not adequately support the degree of market risk measure, monitor, and control market risk; the institution’s taken by the institution. size; the nature and complexity of its activities; and the adequacy of its capital and earnings in relation to its level 4. A rating of 4 indicates that control of market risk of market risk exposure. sensitivity is unacceptable or that there is high

potential that the earnings performance or capital For many institutions, the primary source of market risk position will be adversely affected. Risk management arises from nontrading positions and their sensitivity to practices are deficient for the size, sophistication, and changes in interest rates. In some larger institutions, level of market risk accepted by the institution. The foreign operations can be a significant source of market level of earnings and capital provide inadequate risk. For some institutions, trading activities are a major support for the degree of market risk taken by the source of market risk. institution.

Market risk is rated based upon, but not limited to, an 5. A rating of 5 indicates that control of market risk assessment of the following evaluation factors: sensitivity is unacceptable or that the level of market

risk taken by the institution is an imminent threat to its • The sensitivity of the financial institution’s earnings viability. Risk management practices are wholly or the economic value of its capital to adverse changes inadequate for the size, sophistication, and level of in interest rates, foreign exchanges rates, commodity market risk accepted by the institution. prices, or equity prices.·

• The ability of management to identify, measure, monitor, and control exposure to market risk given the Examination Standards and Goals institution’s size, complexity, and risk profile. The following documents provide additional guidance for • The nature and complexity of interest rate risk managing IRR: exposure arising from nontrading positions.

• Where appropriate, the nature and complexity of • Joint Agency Policy Statement on Interest Rate Risk, market risk exposure arising from trading and foreign • operations. Interagency Advisory on Interest Rate Risk Management, and • Ratings Interagency Advisory on Interest Rate Risk Management Frequently Asked Questions.

1. A rating of 1 indicates that market risk sensitivity is well controlled and that there is minimal potential that Interagency Policy Statement on Interest Rate the earnings performance or capital position will be Risk adversely affected. Risk management practices are strong for the size, sophistication, and market risk In 1996, the FDIC and the other Federal banking accepted by the institution. The level of earnings and regulators adopted the Sensitivity to Market Risk capital provide substantial support for the degree of component of the Uniform Financial Institutions Rating market risk taken by the institution. System and issued a Joint Agency Policy Statement on IRR (Policy Statement). The Policy Statement identifies 2. A rating of 2 indicates that market risk sensitivity is the key elements of sound IRR management and describes adequately controlled and that there is only moderate prudent principles and practices for each of these elements. potential that the earnings performance or capital It emphasizes the importance of adequate oversight by a

Sensitivity to Market Risk (7/18) 7.1-20 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 bank’s board of directors and senior management as well • Bank IRR analysis, as the importance of comprehensive risk management • Independent review or audit findings, processes. The Policy Statement also describes the critical • Related bank policies and procedures, IRR-related factors that affect the Agencies’ evaluation of • Balance sheet and account data, an institution’s capital adequacy • Strategic and business plans, • Product pricing guidelines, and Interagency Advisory-Interest Rate Risk • Derivatives activities. Management Citing Examination Deficiencies In January 2010, the Agencies issued updated guidance to clarify supervisory expectations for IRR management set Material weaknesses in risk management processes, or forth in the 1996 Policy Statement. The Interagency high levels of IRR exposure relative to capital, require Advisory on Interest Rate Risk Management (Advisory) corrective action. Such actions may include re-emphasizes the importance of effective corporate recommendations or directives to: governance, policies and procedures, risk measurement and monitoring systems, stress testing, and internal • Raise additional capital; controls related to IRR exposures. The Advisory indicates • Reduce levels of IRR exposure; financial institutions should manage IRR commensurate • Strengthen IRR management expertise; with their complexity, risk profile, business model, and • Improve IRR management information and scope of operations. Additionally, the Advisory highlights measurement systems; or that effective IRR management involves not only the • Take other measures or combination of actions, identification and measurement of IRR, but also depending on the facts and circumstances of the appropriate risk mitigation strategies that may be used to individual bank. control IRR if exposure levels warrant corrective steps.

If an examiner determines that IRR weaknesses warrant In January 2012, the agencies published supplemental the listing of a contravention of regulatory guidance in the guidance addressing Frequently Asked Questions (FAQs) Report of Examination, the 1996 Policy Statement should on the 2010 Advisory. The FAQs provides additional be cited as the source guidance. Examiners may reference clarification on topics such as determining model the Advisory or the FAQs document in supporting appropriateness; defining meaningful stress scenarios; comments. A contravention of the interagency guidelines analyzing yield curve, basis, and option risk, as well as detailed in Appendix A of Part 364 may also be warranted using no-growth measurement scenarios. The FAQs also for institutions with seriously deficient IRR programs. describe effective procedures for model validations and calculation of non-maturity deposit decay assumptions. Pursuant to Appendix A (II.E.) of Part 364, an institution

should: ←

EXAMINATION PROCESS • Manage interest rate risk in a manner that is appropriate to the size of the institution and the FDIC examination procedures follow a risk-focused complexity of its assets and liabilities; and framework that incorporates the guidelines outlined in the • Provide for periodic reporting to management and the 1996 Policy Statement and the 2010 Advisory (including board of directors regarding interest rate risk with the FAQs guidance) to efficiently allocate examination adequate information for management and the board resources. The scope of an examination should consider a of directors to assess the level of risk. bank’s IRR exposure relative to earnings and capital, the complexity of on- and off-balance sheet exposures, and the Note: Accepting a reasonable degree of IRR is a strength of risk management processes. fundamental part of banking that significantly affects profitability and shareholder values. Although risks must Examiners can identify material exposures and risks by be properly managed, exceptions to established IRR reviewing the following items (most of which are available policies and limits occasionally occur. Examiners should during off-site analysis): not automatically criticize relatively minor exceptions to established policies or internal limits if an institution has • Prior examination findings, appropriate, formal processes for monitoring, reviewing, • Interest Rate Risk Standard Analysis (IRRSA), and approving exceptions. • Net interest margin and net operating income trends, • Board or committee minutes,

RMS Manual of Examination Policies 7.1-21 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

Additionally, examiners are reminded that, if weaknesses account. This assumption is sometimes referred to as in a model or its assumptions are identified that render its replacement growth. results unreliable, report comments supporting the assigned rating should not rely on (or, at a minimum, Dynamic Models should qualify any use of) the resulting data. Dynamic simulation models rely on detailed assumptions ← regarding changes in existing business lines, new business, MARKET RISK GLOSSARY and changes in management and customer behavior. The assumptions change the existing balance sheet to reflect Deterministic Rate Scenarios expected business changes.

Deterministic modeling techniques allow management to specify the direction, amount, and timing of future interest Stochastic Models rates in order to measure the potential impact the changes may have on earnings and capital. The following items are Stochastic modeling consists of the modeling of an examples of commonly used deterministic interest rate uncertain variable over time using a random selection scenarios: process. It recognizes that market variables, such as interest rates, exhibit a general trend (drift) and some • Rate Shock Scenario – In this scenario, rate changes degree of volatility around that trend. Stochastic models are immediate and sustained. For example, in a plus provide a framework for the evaluation of the impact of 300 basis point scenario, the full effect of the rate embedded options in financial instruments. increase would be administered in the first period measured and remain in effect for all periods. Constraints are usually imposed so that the model is • Rate Ramp Scenario – In this scenario, rate changes representative of current market conditions. For example, are applied gradually over the measured period. For if Treasury securities are priced using interest rate paths, a example, when measuring the effects of a 300 basis constraint may be imposed so that the average present point rate increase during a 12-month period, rates value derived from all the paths must equal the observed would be increased 25 basis points each month. market price of the Treasury securities. In such a case, the • Stair Step Scenario – In this scenario, rate changes model can also be classified as a Stochastic No Arbitrage are administered at less frequent intervals over the Model. measured period. For instance, in a 300 basis point increasing rate environment measured over a two-year Monte Carlo Simulation time period, rates may be increased 50 basis points each quarter of the first year and 25 basis points each A Monte Carlo simulation randomly generates a large quarter of the second year. sample set of values from a reasonable population of variables such as an interest rate. The stochastic model Non-parallel Yield Curve Shifts provides a framework for the evolution of the variable, and a Monte Carlo simulation is an application of that A shift in the yield curve in which yields do not change by stochastic model. The randomness in games of chance is the same number of basis points for every maturity. When similar to how Monte Carlo simulation selects values at running various interest rate scenarios, management may random to simulate a model. When you turn a roulette set non-parallel shifts in a manner similar to deterministic wheel, you know that one number within a range of rate scenarios (rate shock, rate ramp, or stair step). The numbers will come up, but you do not know which number scenarios often have a pivot point on the yield curve from will come up for any particular turn. The same concept which longer-term and shorter-term rates change in applies with a Monte Carlo simulation where the variables different amounts. (e.g., interest rates, security prices) have a known range of values but an uncertain value for any particular time. Static Models Monte Carlo simulations can take into account returns, volatility, correlations, and other factors. Monte Carlo

programs can generate millions of different scenarios by Static simulation models are based on current exposures randomly changing a component for each run or iteration. and assume a constant, no-growth balance sheet. In order Monte Carlo simulation allows the banker to simulate to simulate no growth in balance sheet accounts, some thousands of market-like scenarios and learn the static models assume that all principal cash flows from a probability of a particular outcome or a range of outcomes. particular account are reinvested back into that same Assume that the investment portfolio is run through 20,000

Sensitivity to Market Risk (7/18) 7.1-22 RMS Manual of Examination Policies Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1 simulations, projecting 20,000 separate scenarios over a Macaulay Duration Calculation two-year period, and acceptable results occur 16,000 3 year bond, 5% coupon, 10% yield times. This means that there is an 80 percent probability that the portfolio will perform at an acceptable level. Like Year Payment PV x T PVxT any financial model, the results are sensitive to underlying 1 $50 $45.5 x 1 = $45.5 assumptions. The number of runs or simulations is also 2 $50 $41.3 x 2 = $82.6 important. For example, a Monte Carlo model with only 3 $1,050 $788.9 x 3 = $2,366.7 500 iterations captures fewer possible scenarios than one Total $875.7 $2,494.8 that runs 50,000 iterations. T = Time period payment is received Spread Types Macaulay Duration: 2,494.8 / 875.7 = 2.85 years

• Static Spread – Basis points, that when added to a set Modified duration, calculated from Macaulay duration, of implied forward rates, discounts the cash flows of estimates price sensitivity for small interest rate changes. an instrument back to its observed market value. For an instrument without embedded optionality, the static Modified Duration Calculation spread is the best measure of return in excess of the 3 year bond, 5% coupon, 10% yield risk-free rates provided by that instrument. For Macaulay Duration = 2.85 years instruments with embedded optionality, it may be Macaulay Duration useful to calculate a static spread only as a starting 1 + (Yield / n) point for comparison with a more appropriate mark- = 2.85 / 1.10 to-market spread measure, such as the option adjusted spread. n = coupons per year • Option Adjusted Spread (OAS) – Basis points, that Modified Duration = 2.59% when added to a set of interest rates discounts the cash flows of an instrument back to its observed market value. This measure only applies to instruments with The following formula can be used to estimate the embedded optionality. The static spread applies to percentage change in a bond’s price: instruments without embedded optionality. For − example, consider a mortgage-backed security, which Δ % = Modified Duration x Δ Yield x 100 typically contains an embedded prepayment option. Note: The minus sign recognizes the inverse relationship Assume the static spread is 75 basis points. The OAS of price and yield. would be less than the static spread of 75 basis points because the volatility of interest rates reflected in an For a 100 basis point change in rates, the estimated change OAS framework assigns more value to the borrower’s in price is equal to the modified duration. In other words, prepayment option, thus reducing the value to the using a modified duration of 2.59 percent, the price of a MBS investor. bond would change approximately 2.6 percent for every • OAS Process – In a stochastic valuation model, the 100 basis point change in rates. If rates changed by only average value generated by all the interest rate paths 50 basis points, the bond would change approximately 1.3 must equal the currently observed price of the percent. security. The initial computation in the model is Δ% = Modified Duration x Δ Yield x 100 based on an assumed spread. The security value = 2.59% x 50bp x 100 derived is compared to the observed. = 2.59% x .5 = 1.295% Duration Calculations The following formula can be used to estimate the dollar Macaulay duration calculates the weighted average term change in price: to maturity of a security’s cash flows. Assume a bond Δ$ = minus Price x Modified Duration x Δ Yield x 100 with three years remaining to maturity, bearing a 5 percent If the price of the bond had been $875.66, then its coupon rate paid annually, when a 10 percent yield is approximate change in value (price), if rates changed by required. 50bp, would be ($875.66) x 1.295% = ($11.34).

If rates fell, the estimated value would be $887.00, while if rates rose the estimated value would fall to $864.32.

RMS Manual of Examination Policies 7.1-23 Sensitivity to Market Risk (7/18) Federal Deposit Insurance Corporation SENSITIVITY TO MARKET RISK Section 7.1

Duration-based price forecasts are generally precise when V- = Price if yield is decreased by Change Y used with small rate changes (1 to 5 basis points). V0 = Initial price per $100 of par value However, the accuracy of the forecasts decline when larger rates changes (especially 100 basis points or more) are Assume: a three-year callable bond’s current market value involved. The reason for the declining accuracy of price is $98.60 (V0); that interest rates are projected to change forecasts relates to the non-linear relationship between by 100 basis points (Y); that the price of this bond given a prices and yields (a.k.a., convexity). 100 basis point increase in rates is $96.75 (V+); and that the price of this bond given a 100 basis point decrease in Convexity rates is $99.98 (V-).

Option-free financial instruments display positive To calculate effective duration and convexity: convexity. When rates decline, a positively convexed instrument’s price increases at an increasing rate. When Effective Duration = rates rise, a positively convexed instrument’s price (99.98 – 96.75)/(2(98.60)(.01)) = 1.64 decreases at a decreasing rate. Effective Convexity = 96.75 + 99.98 – 2(98.60)÷(2(98.60)(.01))² = -23.83 Negative convexity causes the duration of a security to lengthen when rates rise and shorten when rates fall. If we assume interest rates increase 100 basis points, the Instruments that contain embedded options demonstrate approximate price change due to effective duration is the negative convexity. When rates decline, a negatively following: convexed instrument’s price increases at a decreasing rate. When rates rise, the price of a negatively convexed Percentage Price Change = -Effective Duration x Yield instrument will decline at an increasing rate. Change Percentage Change in Price = -1.64 x .01 = -1.64% For example, the value of the treasury security changes relatively less in value in comparison to the sample The approximate price change due to effective convexity is mortgage security, which declines more significantly. the following: However, as yields decrease, the treasury security gains value at an increasing rate, while the mortgage security ½ x Effective Convexity x (Yield Change)² gains only modestly. As interest rates decline, the ½ x -23.83 x (0.01)² x 100 = -0.12% likelihood increases that borrowers will refinance (exercise prepayment option). Therefore, the value of a mortgage Thus this bond’s price would be expected to decrease by security does not increase at the same rate or magnitude as about 1.76 percent given a 100 bps rise in rates: a decline in interest rates. Effective = -1.64% Effective Duration and Effective Convexity Duration Effective = -0.12% Effective duration and effective convexity are used to Convexity calculate the price sensitivity of bonds with embedded -1.76% options. The calculations provide an approximate price change of a bond given a parallel yield curve shift. Measures of modified duration and convexity do not provide accurate calculations of price sensitivity for bonds with embedded options. Effective duration and convexity provide a more accurate view of price sensitivity since the measures allow for cash flows to change due to a change in yield. Formula:

Effective Duration = (V- - V+)/(2V0 x ΔY) Effective Convexity = (V+ + V- - 2V0)/(2V0 x ΔY)²

Where, ΔY = Change in market interest rate used to calculate new values:

V+ = Price if yield is increased by Change Y

Sensitivity to Market Risk (7/18) 7.1-24 RMS Manual of Examination Policies Federal Deposit Insurance Corporation